Updated: May 14
Welcome back to our series on "Ratio Analysis 101" where we help readers better understand financial ratios and their role in the financial analysis framework. We will be discussing how to conduct liquidity and solvency ratio analysis. So firstly, what are liquidity and solvency?
John, a high-flying salaryman has his paycheck delayed. But he has bills and mortgage repayments for his luxury condominium to cater for. His cash at hand is insufficient but once his paycheck arrives, he will be good to go. He has unfortunately just encountered a liquidity crunch that is temporary-in-nature.
Next, envision that he is retrenched and settled for a job that pays 50% of his previous salary. His high lifestyle and mortgage repayments quickly deplete his savings. If he is unable to pay, he risks becoming insolvent and having those assets foreclosed. This is what a painful insolvency looks when the borrower is no longer capable for meeting his mortgage payments.
With that definition in mind and a greater appreciation of the dangers of illiquidity and insolvency, let's get started! Do feel free to leave a comment or feedback.
TABLE OF CONTENT
Understanding The Balance Sheet
Debt vs. Equity Financing
Why Liquidity and Solvency Matter?
Liquidity I - Current, Quick and Cash Ratios
Liquidity II - Cash Conversion Cycle
Liquidity III - Working Capital Management
Solvency I - Debt to Asset and Equity Ratios
Solvency II - Debt/EBITDA, Interest and Debt Service Coverage Ratios
UNDERSTANDING THE BALANCE SHEET
To measure liquidity and solvency ratios, a financial statement user cannot make do without the balance sheet. Also known as the Statement of Financial Position, it contains information about the business's assets, liabilities and equity at a specific point of time (ie. 31 December 20XX),. In contrary, the P&L and Cash Flow statements] contain their information over a period of time. The balance sheet provides users with important information on the business's capital structure and liquidity.
Assets are resources owned by the business to produce future economic benefits. The balance sheet records the monetary value of assets, which can be classified into current and non-current assets. Current assets are resources that are or expected to be converted into cash within the next financial year, while non-current assets are expected to do so beyond the financial period.
There are tangible assets such as Property, Plant and Equipment (PP&E) and intangibles, which describes assets without a physical presence but still expected to generate economic benefits such as intellectual property rights. The value of an asset should be measurable in monetary terms before it can be recorded in the balance sheet. Thus, items which generate economic benefits but cannot be measured, such as branding, human capital, etc, are not recorded.
Liabilities represent a probable future outflow of economic benefits from the business. Current liabilities such as trade payables and accrued liabilities will come due within the next financial year while the payment to settle non-current liabilities, such as repayment for the non-current portion of a bank loan, is expected to occur beyond the financial period. Lenders are also viewed to have priority claims on the company's assets when the company becomes insolvent and goes into liquidation.
Equity is the residual claim or ownership of the business after deducting all liabilities. Additional share capital, retained earnings, revaluation surplus, etc, increase equity while net loss, dividend payment, shares repurchase, reduces equity. If equity is very low or negative, it suggests that the company could possibly be insolvent.
The accounting equation states that at all times, assets must be equal to the sum of all liabilities and equity. It is also critical to examine the makeup of assets and liabilities as it gives a rough picture of the amount and timing of cash inflows and outflows, as well as suggests the proportion of assets that can be converted to cash quickly and without significant costs.
DEBT VS. EQUITY FINANCING
A business may choose to raise fund through debt and equity financing. We will discuss the characteristics of both financing modes and explore the possible reasons why businesses choose the option.
The company is not required to share a portion of its profits with lenders.
High leverage as change in sales have an amplified effect on profits.
Repayment structure is fixed and can be customized to match cash flow.
Lenders enjoy theoretically higher priority of claim.
Debt financing are more suitable for companies with stable cash flow.
Interest expense is tax-deductible resulting in a cheaper cost of capital.
Creditors are risk-averse and might insert clauses to discourage risk-taking.
Can pledge collateral to further lower risk, resulting in an even cheaper cost of capital.
Only need to abide by the bond covenant /loan agreement during the loan term.
The company is required to share a portion of its profits with lenders.
Founder's voice is diluted and might be subject to unrealistic shareholders' expectations.
Shareholders' interests are vested and their shares grow and fall with the company.
Incur higher internal control costs as shareholders might demand more monitoring.
Dividend is paid at the management's discretion so more financial flexibility for the firm.
Shareholders have the lowest priority claim during liquidation.
The most shareholders can lose is the amount they invested (Limited Liability).
Shareholders demand higher return (dividend and capital gain) for the higher risk.
In Singapore, dividend is only taxed once at corporate-tax level and capital gain is tax-free.
WHY LIQUIDITY AND SOLVENCY MATTER?
In business, cash is the king! One does not pay her suppliers and employees with profits! Liquidity describes if there is a ready market for an asset and how easily can it be converted into cash quickly and without significant loss in value.
The most liquid of assets are cash and marketable securities, while many non-current assets such as investment properties, PP&E, etc require significant time and cost to liquidate. Therefore, liquidity measures if there are enough cash and other liquid assets to settle outstanding liabilities as they come due within the year,
Solvency describes the ability of a company to meet its long-term debt obligations and continue operating into the foreseeable future. This is important as most creditors lend on the premise that the fund will be repaid. So lenders would have assessed the creditworthiness of borrowers and deemed them as an acceptable risk at the point-of-lending.
But the future might play out different from expectations and the business's cash flow might decrease. If the dip is temporary in nature, it should not be worrying as long as the company sets aside sufficient reserve. However, if the drop is brought about by something more permanent such as obsolete technology, sunset industry, etc, the ability of the company to repay and its solvency will be called into question. If the company defaults, the lender has to right to call the loan and if the borrower is unable to repay, its assets could be foreclosed and liquidated.
Morgan is the manager of Pi Construction Inc. Her firm secured a project to construct a condominium development. To finance the project, she contacts the bank for a loan application. Before submitting the financial statement, Morgan glances at the firm's balance sheet.
LIQUIDITY I - CURRENT, QUICK AND CASH RATIOS
The current ratio measures the adequacy of the working capital and the ability of the business to repay its short-term obligations. So the question is what number is the most optimal? If it is negative, the company might face a liquidity crunch. But if the ratio is significantly higher than its peers without any clear strategic purpose, the business is maintaining too much idle working capital.
Therefore, to yield meaningful analysis, a manager should compare its ratio against past and expected performances to determine the trend, as well as against key competitors and industry average to ascertain relative performance. For Pi Construction Inc., its current ratio is 1.11 (100 ÷ 90). The current asset level deemed to be sufficient to cover current liabilities.
QUICK RATIO (AKA ACID-TEST RATIO)
The quick ratio is a more stringent measure of liquidity, by removing inventory and prepaid expenses from current assets. The aim for measuring it is to assess how capable the business is in paying off its short-term obligations using assets that can be quickly converted to cash quickly and without significant discount.
On the current asset side, inventory which includes work-in-progress and finished goods requires a significantly longer time to sell. It may also be obsolete and susceptible to spoilage. The prepaid expenses are payments made-in-advance and therefore, cannot be liquidated into cash. On the current liability side, unearned revenues are payments received-in advance so it represents a performance obligation, not an exact cash outflow.
Morgan proceeds to calculate the quick ratio of 0.625 ([100 Current Assets - 30 Inventory - 10 Supplies - 10 Prepaid Expense] ÷ [90 Current Liabilities - 10 Unearned Revenue]).
Cash ratio is the most stringent measure of liquidity ratios, as it only includes cash and the highly liquid marketable securities in the numerator. It measures the ability to pay off all short-term obligations if they become due immediately. Marketable securities are high-quality short-term debt instruments that can be converted into cash quickly and at minimal costs, such as fixed deposits, government t-bills, bankers' acceptance, etc.
Morgan continues her analysis by computing the cash ratio for Pi Construction Inc. and it stands at 0.25 ([10 Current Assets - 10 Inventory] ÷ [90 Current Liabilities - 10 Unearned Revenue]). She also finds out that although the ratio is low, it is in-line with the industry's average as inventory gets moved quickly to cost of sales with the progress claim system.
LIQUIDITY II - CASH CONVERSION CYCLE
The operating cycle (OC) measures the average period of time required for the business to produce, sell the goods, and receive cash from customers. When a company kickstarts the production process, it transfers Raw Material (RM), which is distinctly accounted from inventory, into the production process as direct material. The direct material, labour and production overhead expenses incurred are added and recorded as Work-In-Progress (WIP) inventory. Once production is completed, WIP is transferred into Finished Goods (FG) inventory and remains there until the good is sold, when it is transferred to COGS. If the sale is a credit sale, the business can reasonably expect that payment shall be made before the credit due date.
The days of inventory at hand (DIH) approximates the period (measured in days) it takes from the start of the production to the time the product is sold. The shorter the time period, the more efficient the production and inventory management processes are.
The reason average inventory value is used is due to the balance sheet, which presents values at a single point in time. But COGS in the P&L statement records the value over the reporting period. To ensure consistency, the average level of inventory over the period is used. In our example, the COGS extracted from Pi Construction Inc.'s income statement is $300.
The average inventory level for the period is $25 or [$30 Inventory(20X9) + $20 inventory(20X8)] ÷ 2. The DIH is 30.4 days or [$25 x 365 Days] ÷ $300 COGS. The shorter the DIH, the lesser time it takes the firm to produce its good and the shorter time that invested working capital is locked up as inventory.
The days of sales outstanding (DSO) estimates the number of days it takes for the business to collect the payment after the product is sold on credit. It is dependent on the company's credit policy and the effectiveness of its collection.
The average receivable level for Pi Construction is $25 or [$30 Receivables(20X9) + $20 Receivables(20X8)] ÷ 2. As the revenue extracted from the P&L statement is $500, the DSO is 18.3 days or [$25 x 365 Days] ÷ $500 Revenue. The OC or days it takes to recover working capital invested in inventories equals to 48.7 days.
CASH CONVERSION CYCLE
The cash conversion cycle (CCC) is a measure that expresses the NET number of days it takes for the business to convert its working capital investments back to cash flows by accounting for the days of payables which represents borrowed capital from the suppliers and vendors.
The days of payables (DOP) captures the days it takes to settle payables and it involves the purchase of raw material. The longer the time period, the more the company is able to take advantage of the suppliers' credit terms and shorten the NET time that working capital is locked up in inventory and receivables.
The average level of payables is $30 or [$40 Payables(20X9) + $20 Payables(20X8)] ÷ 2. The DOP for Pi Construction Inc. stands at 31.3 days or ($30 x 365 Days) ÷ 300 COGS = 36.5 Days. Therefore, the CCC is 12.2 days (48.7 OC - 36.5 DOP). CCC is a good measure of liquidity as it breaks down liquidity into the 3 components. But to further enhance the analysis, Morgan can also calculate the CCC of peers to gain insight into the relative performance in each of the 3 areas.
LIQUIDITY III - WORKING CAPITAL MANAGEMENT
It is important for internal users of financial information, such as managers and accountants to manage the company's liquidity position by identifying the Pulls and Drags on liquidity, as well as coming up with risk measures to meet unexpected liquidity problems.
CASH FLOW MANAGEMENT
The key to proper working capital management is a proper and realistic budgeting process. If the budgeting assumptions are realistic, the result should be a properly done proforma statement and cash budgets. The cash budgets will allow a manager to reasonably anticipate the level and timing of cash inflow and outflow. The illustration below is of a sample cash budget.
It is also a good practice to set aside a minimum sum of cash in the bank at all times. If the cash level rises above the threshold, the excess could be invested in highly liquid marketable securities to generate returns until it is deployed for other uses. If cash dips beneath the minimum sum level, it should be restored back to the threshold level by firstly liquidating the marketable securities. If the liquidity crunch is prolonged, the firm might have to contemplate taking up short-term financing. For example, some managers sign up revolving line-of-credit with financial institutions to insure the company against such situations. Although not advisable, some corporations may also monetize accounts receivables through a factoring arrangement.
DRAG ON LIQUIDITY
Drags are factors that slow down cash inflow, such as uncollected receivables, obsolete inventory, etc. Management can reduce drag by properly analyzing the customer's creditworthiness before assigning the customer a credit limit and term based on the firm's risk appetite. A business can also encourage customers to pay early, set up an effective collection team, and adopt an efficient inventory management system to reduce overproduction and inventory obsolescence.
PULL ON LIQUIDITY
Pulls are factors that promote the accelerated disbursement of cash, such as early settlement of receivables and reduced credit limit due to previous delinquency. The responsibility lies with the management to not settle payables too early nor risk pissing-off suppliers by persistent late/non-payment. With good payment history, the firm may also negotiate lower prepayment and longer credit terms.
SOLVENCY I - DEBT TO ASSET AND EQUITY RATIOS
Solvency describes the ability of a company to meet its long-term debt obligations and continue operating into the foreseeable future. There are 2 ratios that provide an overview of the firm's capital structure. However, when viewed in isolation, it offers little indication for the company's ability to meet debt obligations.
There are several drawbacks if a financial user takes it at face value. Firstly, the non-current asset reported on the balance sheet is its net book value (purchase cost - accumulated depreciation). But the book value may deviate from its actual market value. Although fixed assets are checked for impairment at least annually, the value of illiquid fixed assets is subjective. Lastly, debt could be intentionally or unintentionally concealed by off-balance-sheet (OBS) financing.
WHAT IS OFF-BALANCE-SHEET FINANCING?
OBS financing refers to assets and liabilities that do not appear on the balance sheet but has a material influence on the company's finances. Under risk-sharing arrangements such as joint ventures and equity investments (between 20% to 49%) in another business entity, the investing company only records the purchase cost under assets and pro-rated share of the JV or investee's subsequent net incomes in the P&L statement. No liability is recorded in this transaction. Some investors also guarantee loans on the behalf of its investees.
A contingent liability is an obligation that is possible but not probable, such as a potential settlement pending on the outcome by the court, the company acting as a guarantor for the loan/listing of another company, etc. Under the prevailing accounting standard, an obligation is only required to be recorded when both the amount can be measured and it is probable.
Selling receivables to a factoring company (with recourse) is also considered an OBS financing arrangement. While receivables are sold to a factor in exchange for upfront cash for a fee, to comply with the existing accounting standard, the firm is only needed to declare an estimated % of collectables as recourse obligations under liabilities. However, if the loan cannot be collected, the corporation is still ultimately responsible for the liability.
Operating lease used to be a significant OBS financing method. Before IFRS 16 took effect, a business used to be able to report the periodic lease payments as an expense. But in substance, entering into a lease agreement is essentially similar to committing to a predetermined payment schedule, which makes it essentially an obligation. Businesses are now required to report the present value of the lease payments as an asset and a liability. This standard also applies to hire-purchase agreements.
WHY OBS AND HOW TO DEAL WITH THEM?
One motivation that spurs managers to resort to OBS financing is to “window-dress” the company’s finances to fool investors and creditors. For example, some managers might resort to artificially deflating its liabilities to avoid violating the bank’s loan covenant. Because when the firm violates the covenant, the financial institution has the right to call the loan and demand immediate full repayment of the remaining outstanding.
Despite it being "off the balance sheet", information on them can be found buried in the footnotes. If uncovered, one should add them to the asset and liabilities and recalculates the adjusted Debt/Asset and Debt/Equity ratios. One could then compare the new against the original ratios. Doing so will allow one to assess the impact of the OBS item and get a better overview of the organization’s true solvency and financial position.
SOLVENCY II - DEBT/EBITDA, INTEREST AND DEBT SERVICE COVERAGE RATIOS
The 3 ratios help to measure the business's ability to continue meeting its debt obligations in a bid to avoid becoming insolvent.
EBITDA is the abbreviation of Earnings before Interest, Tax, Depreciation and, Amortization. It is a quick and dirty method of estimating the cash flow of operating activities (CFO) by excluding significant non-cash items such as depreciation and amortization and other non-operating incomes and losses. The Debt/EBITDA ratio measures how many long does it take to fully repay all liabilities using EBITDA. A relatively high Debt/EBITDA ratio compared to its peers and industry average may imply that the firm is over-leveraged.
Financial institution and credit rating agencies also use this important metric to measure the borrower's ability to repay. With a little algebraic manipulation, a manager is able to estimate the approximate amount of money (such as 5.0x of EBITDA) that financial institutions are willing to lend. To score well in the credit analysis department, it is important to have a healthy, sustainable and stable EBITDA, for the past and the forecasted future. Therefore, the project you are financing must make sense economically while the Debt/EBITDA multiple used by the lenders is variable and depends on the general economy, the bank's risk appetite, the availability of capital, the business’s 5Cs (Capacity to repayment, Character, Covenant, Condition and Collateral), etc.
INTEREST COVERAGE RATIO
The Interest Coverage Ratio measures the ability of the firm to service its interest expense using its recurring operating income (EBIT). It measures how many times the EBIT covers interest and a high ratio is indicative of the firm’s financial position and capacity to assume debt.
It is typically used to measure the solvency of a company which raised fund using the publicly-listed bond as unlike loan, only the periodic coupon repayments (ie. 5% of face value) are made during the interim periods, which is usually closer to the interest rate.
In the meantime, the business also has to set aside sufficient cash to settle the face value at maturity. or secured a plan to refinance the amount outstanding when it is due. The information on the bond structure can be found in the footnote disclosures. If the ratio is close to 1.0, the company faces insolvency. However, if the ratio is comparatively higher than its peers, and with everything else equal, a company might not be assuming sufficient debt to generate higher returns for its owners.
DEBT SERVICE COVERAGE RATIO
Debt Service Coverage Ratio (DSCR) measures the ability of the firm to service its interest and principal repayment by utilizing its net operating income (NOI), which is calculated by adding interest expense to EBITDA. It is an important measure if the majority of the business's long-term debt is funded by amortizing loans, such as a syndicated bank loan. The higher the ratio, the more solvent the company is.
If the ratio is close to 1.0, the company faces diminished returns in capital borrowed and therefore, needs to urgently restructure its capital structure and operations to prevent insolvency.
HOW TO CONDUCT SOLVENCY ANALYSIS?
Solvency is the measurement of the firm's ability TO MEET debt obligations, not measuring how well the firm HAVE MADE payment in the past. Although the repayment structure for loans is fixed, the business's projected earnings might differ from its actual takings. That is why it is important to conduct solvency analysis on past historical information, but relying on it alone is dangerously insufficient as past performances do not equal to future performance.
To create a financial model, the first step is to analyse the firm's past finances. The track performance, combined with market insight, will help power assumptions to project the company's financial performance into the foreseeable future (should cover the loan term at the very least). Solvency ratio analysis shall then be conducted on the company's expected performances to assess its ability to meet future debt obligations.
It is also important to plan multiple scenarios to stress-test the business's ability to meet future debt obligations under adverse conditions. For example, when sales decrease by 30% or when a key input increases in price sharply or the firm experiences an interest rate spike when the company has assumed variable-rate debt.
After the scenario analysis is conducted, managers have to plan for contingencies for each scenario. For example, before formalizing the contract to construct the condominium development, Morgan conducts solvency ratio analysis on the developer's finances and to safeguard against a prolonged recession scenario, she signs an escrow agreement with the developer. She also increases the minimum cash balance in the bank to a level that is sufficient to meet 60 (from 45) days of projected operating expenses in the event of late payment. She also inserts the requirement in her RFP that for certain key tasks, her vendors would have to purchase surety bonds after the contract is awarded.